Does Readability of Financial Disclosures Affect the Bond Market?

Going back as far as the Securities Act of 1933, the Securities and Exchange Commission has taken action to improve the readability and understandability of financial data. In 1969, a report commissioned by the SEC, the Wheat Report, indicated that the length and complexity of prospectuses made it difficult for the average investor to understand them. The Wheat Report recommended the avoidance of long, complex, or verbose writing. In 1997, while chairman of the SEC, Arthur Levitt revisited the issue of writing complexity in financial reports during a speech to the Securities Regulation Institute, suggesting that “[i]n many cases, the problem is not a lack of information; quite the opposite. Too much information can be as much a problem as too little. More disclosure does not always mean better disclosure.” As public company regulatory filings with the SEC have become increasingly longer and less readable, so have the concerns about the implications of poor communication.

To address these concerns, the SEC adopted the 1998 plain English regulation (SEC Rule 421(d)), which required registrants to use plain English principles in their prospectus documents. Concurrently with the adoption of Rule 421(d), the SEC published “A Plain English Handbook: How to create clear SEC disclosure documents.” Our study, recently accepted for publication by the Review of Accounting Studies and available here, examines credit ratings issued by Standard & Poor’s (S&P) and Moody’s Investors Service (Moody’s) and yields on newly issued bonds to determine whether the readability of companies’ annual reports filed with the SEC affects their cost of debt financing.

Our study focuses on debt market consequences of readability in part because of the sheer size of the corporate bond market—there were approximately $1.5 trillion worth of new bond issuances during 2015—but also because rating agencies like S&P and Moody’s have such an important impact on the pricing of bonds. There is a decent understanding of the effects of quantitative accounting information on the rating and cost of debt financing. However, the impact of financial disclosures, particularly textual attributes, on the bond rating process has gone relatively unexplored.

Given that qualitative information makes up a substantial portion of mandated filings, the role of this narrative portion makes it an especially important factor to consider in the bond rating process. We investigate whether, and to what extent, less clear (i.e., readable) narrative disclosures are associated with less favorable ratings (higher default risk), greater bond rating agency disagreement, and a higher cost of debt capital. We posit that less readable narrative disclosures are more difficult to process and generate greater rating agency uncertainty about firms’ fundamentals, which leads to less favorable ratings and a greater propensity for disagreement between agencies.

In particular, we examine 3,659 corporate bond issuances made between 1994 and 2014. Overall, we find that less readable annual reports are associated with less favorable credit ratings from S&P and Moody’s and more frequent and larger magnitude disagreements between S&P and Moody’s about the initial rating of a new bond. We also find evidence that less readable annual reports are associated with higher costs of debt financing. In terms of magnitude, we find that if a company improved its readability from the 75th to 50th percentile in our sample, then it would save approximately $440,000 annually in interest for a bond with a face value of $430 million, the average in our sample. This result suggests that the effects of readability on companies’ cost of debt financing appear substantial.

As discussed above, the SEC adopted Rule 421(d) in 1998, which required SEC registrants to use plain English readability principles in the design of their prospectuses. We use the adoption of this regulation as a means to test the causal effects of readability of the cost of debt capital. We compare companies that had active shelf registrations at the time of Rule 421(d)’s adoption with those that did not. The non-shelf registrants that issued bonds immediately after the adoption of the SEC plain English regulation would have to write a fresh prospectus using plain English style, whereas the shelf registrants could rely on the already-filed shelf registration statement until its expiration. We find that the readability of the prospectuses for non-shelf registrants does indeed improve by nearly 9 percent relative to the median levels prior to the regulation. In addition, we find that credit ratings from S&P and Moody’s are more favorable, disagreement between Moody’s and S&P is less frequent and smaller, and offering yields are narrower—by nearly 24 percent relative to the pre-regulation period.

Although the SEC’s efforts to improve the clarity of disclosures by public companies were aimed at retail investors, our study suggests that readability can also affect sophisticated users of financial information such as bond rating agencies like S&P and Moody’s and investors in the corporate bond market. Overall, it appears that disclosure readability can have important consequences for companies’ cost of borrowing.

This post comes to us from Professor Samuel Bonsall at Ohio State University’s Fisher College of Business and Professor Brian Miller at Indiana University’s Kelley School of Business. It is based on their recent article, “The Impact of Narrative Disclosure Readability on Bond Ratings and the Cost of Debt Capital,” available here.

1 Comment

anon

Interesting article. I’m a rating analyst at Fitch Ratings and think you may be missing something here. Complexity in an issuer’s document is often a symptom, not a cause, of weaker ratings – i.e. complexity in describing your business often means your business is complex and therefore risky, which is what the credit ratings reflect. It’s also important to remember that credit rating agencies are engaged in substantial interaction with the entities they rate, and are likely not relying exclusively on public disclosures for their analysis (we receive significant non-public info). Nevertheless, interesting items to consider when it comes to ratings and public disclosure. I would be interested to see if lower readability also correlates with weaker stock price multiples relative to industry peers (or other similar ideas).